ISDA highlights a selection of research papers on derivatives and risk management         

What Do Quoted Spreads Tell Us About Machine Trading at Times of Market Stress? Evidence from Treasury and FX Markets during the COVID-19-Related Market Turmoil in March 2020

Board of Governors of the Federal Reserve System FEDS Notes
By Dobrislav Dobrev and Andrew Meldrum

The FEDS note examines the deterioration in trading conditions for Treasury securities, Treasury futures contracts and other futures markets during the coronavirus-related market volatility in March 2020. While bid-ask spreads for on-the-run Treasury securities remained relatively tight in previous periods of market stress, bid-ask spreads widened sharply in March 2020.

By using high-frequency data on quotes and executed trades, the note provides insights into how market participants changed their order placement and execution of trades. The authors suggest that market participants, including both principal trading firms and dealers, became less willing to replenish the order book fast enough to keep quoted bid-ask spreads consistently tight. This may have amplified the initial shock to liquidity, particularly for 30-year bonds.

The analysis shows that liquidity conditions in Treasury futures markets deteriorated less than those in Treasury cash markets. The note also finds that other liquid futures markets, including foreign exchange (FX) markets, exhibited greater strains than Treasury markets, except for the 30-year ultra-Treasury bond futures. This finding points to a systemic nature of the market turmoil in March 2020 that extended beyond differences in market structure and participation.

The authors find evidence that some market participants in the Treasury and FX markets that employed machine trading strategies were able to mitigate the increase in trading costs by executing trades when market liquidity conditions were more favorable and bid-ask spreads were relatively tight. This finding underscores the potential benefits from the use of sophisticated algorithmic execution strategies that can adapt rapidly to changing liquidity conditions.

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The Impact of Margin Requirements on Voluntary Clearing Decisions

By Esen Onur, David Reiffen, and Rajiv Sharma

The paper analyzes the impact of the non-cleared margin rules on clearing decisions of financial market participants that transact in cash-settled FX swap markets. Specifically, the paper focuses on the impact of the rules on non-deliverable forward (NDF) markets.

Market participants that are covered by the non-cleared margin rules are required to post collateral on their non-cleared swaps. The rules increase the incentives of covered entities to clear, as the margin required for non-cleared swaps is generally higher than for cleared trades. Additionally, there may be netting benefits from clearing.

The study finds there was an increase in NDF clearing rates following initial implementation of the margin rules. By comparing NDF clearing rates to clearing rates for other FX products that are not subject to the rules (FX deliverable forwards and swaps), the authors conclude that the increase in NDF clearing rates was not due to factors common to all FX swaps, but rather was specific to NDFs affected by the new regulation.

The analysis also shows that the increase in NDF clearing was almost exclusively due to a change in behavior by the entities that were directly affected by the margin rules. Within those financial entities, the change in clearing was primarily the result of an increase in clearing by clearing members (CMs), while clearing by non-CMs remained infrequent.

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Cross-border Credit Derivatives Linkages

European Systemic Risk Board Working Paper Series
By Benedetta Bianchi

This paper analyzes the relationship between cross-border holdings of credit derivatives and cross-border investment linkages in the European Union.

The analysis provides stylized facts on the holding countries and sectors, and on the countries of residence of the underlying reference entities. The study shows that gross credit derivatives linkages map to the financial linkages resulting from international investment flows. In other words, larger amounts of credit derivatives are bought and sold on residents of financial partner countries.

The paper also analyzes net credit derivatives positions, differentiating between net buyers and net sellers of protection. It shows that when countries are net buyers, they purchase more net protection on countries to which they have larger portfolio debt exposure on average. This tends to reduce bilateral credit exposures. Conversely, when countries are net sellers, they tend to sell larger amounts of protection on countries where they have larger portfolio debt holdings, thereby increasing their exposure.

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